New Reality: Less for More

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You know the one about the guy who went to a local diner and then complained, “The food was terrible, and there was so little of it”? The same could be said of directors’ and officers’ liability insurance.

“It’s a whole different animal right now,” says Wayne Salen, director of risk management for First Niagara Financial Group Inc., which just renewed its D&O policy in January. His insurer handed the company a 20 percent premium increase for the same coverage limits. And he’s grateful. In general, D&O premiums are running at least 30 to 50 percent higher this year than last. But it’s the insurer’s attitude that rankles, he says. “Everything was far more intensive, more time-consuming. They just wanted volumes of detail. It was unlike anything I’ve ever seen before, and I’ve been in risk management for 25 years,” says Salen, who is also a board member of the Risk and Insurance Management Society.

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This time you can’t blame Enron–at least not entirely, although the losses the insurance industry expects to realize on Enron’s D&O claims are serving as a convenient excuse to raise rates. The industry points its finger at the jump in securities class-action suits in the past year as the main motive for the steep increases.

But this is a bit of a red herring, according to Jim Newman, executive director of Securities Class Action Services. Although the number of suits did jump dramatically, from 293 in 2000 to 511 in 2001, more than 300 of those suits were related to the fraudulent and allegedly widespread practice by underwriters of offering shares in initial public offerings in exchange for kickbacks and other side deals. Even including those anomalous cases, the number of suits per public company has been stable, says Newman.

The real driver of premiums is the recent trend toward astronomical securities class-action settlements, says Newman. The three largest D&O payouts in history were paid or proposed in the past two years: Cendant’s came in at $3.2 billion, Bank of America has proposed $490 million, and Waste Management has proposed $457 million. “In the past, a large claim was $100 million,” says Susanne Murray, senior vice president and D&O liability practice leader at Willis Group Holdings Ltd. “Suddenly, we hit the billion-dollar range.”

The Real Reason

Although insurers aren’t talking about it much, the other reason for D&O increases is that, until 24 months ago, those policies were dramatically underpriced. Many industry watchers say the current increases are simply a long-overdue correction.

Whatever the cause, a policy that formerly cost $400,000 for $25 million of coverage might now cost $1 million. It also may be harder for companies to get all the coverage they seek. Traditionally, D&O insurance policies were written by one primary insurer and a group of secondary insurers, each of which assumed a portion of the risk. Today, companies must line up more carriers to get the same coverage. “Insurers are unwilling to offer as much risk coverage on any one company as they did, mostly because the reinsurance market is less eager to buy it,” says Murray.

Insurers are also introducing new policy language that guts many D&O protections and could cost companies millions. For instance, some now seek to increase deductibles and remove the deductible waiver (which would allow the company to recoup the deductible if it wins a case). Many insurers are demanding that clients agree to co-insurance, which requires the company to pay a portion (usually 10 to 20 percent) of the entire cost of the claim. “We’re looking at having customers share in the risk as a means of managing premium increases and enhancing partnership when claims occur,” says Jim Proferes, deputy D&O underwriting manager for The Chubb Group of Insurance Cos. Translation: in exchange for putting a little skin in the game, companies get smaller premium increases, as well as a powerful incentive to fight harder should claims be made.

The list of changes goes on: multiyear policies are a thing of the past; noncancelable insurance is heading that way; and insurers now charge handsomely for entity coverage, which covers a corporate entity’s liability in shareholder claims. Companies can also expect problems getting employment practices liability coverage as well as coverage of punitive and exemplary damage payments in states where such coverage is allowed.

Canceling Coverage

Perhaps most disconcerting is that insurance companies now seem quite willing to cancel policies or exclude coverage for certain claims, a company’s “worst nightmare,” according to Stephen Weiss, a partner in the Washington, D.C., office of law firm Holland & Knight. “When you buy insurance, you’re trying to buy certainty and cap your liabilities. Pulling the rug out from under you…is so inconsistent with what [insurers] are selling that they won’t talk about it.”

But companies renewing their D&O policies absolutely should talk about it. Cancellation of a policy for nonpayment has always been standard, but insurers now want to make it easier to rescind a policy by making it harder to get a “severability” clause. This clause means that if an insurer finds material misstatements on an application, it can revoke the insurance policy, but only for the person who filed the application; other directors and officers remain protected. These days, severability clauses are getting more expensive–when they can be obtained. Some insurers simply refuse to offer them.

Moreover, insurers are increasingly willing to view a restatement of earnings as a grounds for rescission, using the material-misstatement angle. The St. Paul Mercury Insurance Co. and Royal Insurance Co. of America, two of Enron’s pool of D&O insurers, have made filings in the U.S. Bankruptcy Court indicating that they reserve the right not to honor their contracts, because they are based on just such “material misrepresentations.”

To mitigate the risk of such filings against other companies in the future, the National Association of Corporate Directors (NACD) is recommending that corporate directors and officers participate in education programs that should help them fully understand and focus on their corporate governance responsibilities. “It will take a while for people to focus on the other side of this problem,” acknowledges Peter Gleason, vice president of research and development at the NACD. “We have to go from ‘What do we do about this?’ to ‘How do we alleviate the problem to begin with?'”

Going without D&O insurance simply isn’t an option for a public company. And, ironically, there is plenty of insurance out there, observes James Swanke, a principal with Tillinghast- Towers Perrin and head of its strategic risk financing practice. “There’s more capacity today than there was two or three years ago. You just have to pass through the rigorous underwriting screen and cherry-picking process that they’ve set up.”

In today’s directors’ and officers’ insurance market, a lot of risk managers feel like wallflowers at the high school dance. But with a quick makeover, it is possible to attract an insurer that’s willing to offer the right coverage at a reasonable premium. Here’s how.

Return to risk management.

Risk managers who shopped their policies during the soft market are feeling the brunt of premium increases today. “Risk management is not just the insurance-buying department,” says Rich Sarnie, director of risk management at Iselin, New Jersey-based Engelhard Corp., a materials science and surface chemistry company that renewed its D&O policy in November 2001 with only a 10 percent premium increase. He attributes the low increase to a strong, long-standing relationship with his carrier. “It doesn’t happen overnight,” says Sarnie. “You try to establish a very good relationship with a few good insurers across your entire portfolio. Then you spread the risk so they’ll be less likely to sock it to you when the market turns.”

Start the renewal process early.

The month before your policy expires is way too late, says James Swanke, a principal with Tillinghast-Towers Perrin.

Have open communication with both your broker and primary insurer.

“Ultimately,” says Jim Proferes, deputy D&O underwriting manager for The Chubb Group of Insurance Cos., “it’s the character and the quality of the individuals we’re insuring [that determine premiums]. We find great value in face-to-face meetings to discuss their strategy, financial position, and returns, as well as corporate-governance procedures.”

If you’ve got dark spots on your claims history, claims pending, or off-balance-sheet liabilities, now is the time to reveal them.

Dot your i’s and cross your t’s, counsels Swanke, and don’t put anything on the application that could even remotely be construed as misleading or fraudulent.

Make your application easy to read.

The easier it is to read, the faster it will be read, says Swanke.

Consider a captive, or self-insure a portion of total risk.

Captives can reduce or stabilize costs, improve control over coverage and claim settlements, gain access to the reinsurance market, and improve cash flow and coverage continuity. They also cost a lot to capitalize and run, can increase company exposure to excessive settlements, and can be difficult to structure due to the nature of D&O insurance. “These are low-frequency, high-severity incidents,” says Swanke. “It’s hard to project what your losses would be year to year, so how do you finance that?” He advises his clients who are looking for alternatives to self-insure a portion of the risk, “to the point where a traditional or reinsurance carrier is willing to attach.” — K.F.